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FOUNDATIONS OF FINANCIAL ANALYSIS AND INVESTMENT

"Critically review the theoretical and empirical literature which investigates the impact of bank regulations, market structure, and institutions on the cost of financial intermediation?"

Abstract

In the current economic downturn, banks have been associated with a severe decline in the supply of credit and weakening of banking system of many major banks. However it is widely known that the banking system is the largest sector in the financial system and any financial development has positive impacts on economic growth. In that respect major banks are aware of the financial turbulence and are stepping up efforts towards a stabile financial system, that promotes efficient savings and investments, which are importantly crucial for a thriving market economy. Many experts make efforts to assess the banking efficiency, while it is highly important in explaining and interpreting banking performance. This empirical and theoretical study deal with investigating the impact of bank regulations, market structure, and institutions on the cost of financial intermediation (COFI). The cost of financial intermediation generally reflects the overall bank efficiency, which is measured by net interest margins and bank overhead expenditures. It is obvious that banks tend towards lower levels of overhead costs, as they signal greater efficiency and vice versa excessive overhead costs breed bank inefficiencies. In terms of net interest margins, which focuses on the lending and borrowing operations of banks, have major effects on bank efficiency as higher net interest margins can signal inefficient financial intermediation. In that respect, the main reason for investigating the impact of bank regulations, market structure, and national institutions on the two measures of bank efficiency is to understand the significant, positive and negative relationship between bank efficiency and the impact of bank regulations, market structure, and institutions on it. The paper is structured as follows. The next section presents an introduction of the literature on COFI followed by a short examination into bank regulations, market structure, and institutions. The following sections briefly examine and present the impacts of bank regulations, market structure, and institutions on COFI using empirical and theoretical studies.

I. Introduction

In the current financial disturbance throughout the country, consequent failures and bad performance of national and state banks have started to hit headlines. Since then liquidity seems to have evaporated almost entirely from banks, automobile companies, and many more multinational companies. As a result of the financial turbulence, the challenge for bank remains to make excessive profits and expect to generate enough revenue to offset bank cost. Profit in another sense is crucially the bottom-line or indicator showing the effects of newly introduced bank policies and activities. In other words, bankers pay a great deal of attention to the message that is revealed by any changes in the cost and revenue structure of the banking system. In today's economic environment, many factors can influence a bank�s efficiency: For instance, it is possible that "inflation may increase operating costs faster that income" (Brajovic & Greuning, 2009, p.114).In reference to increasing operating costs, banks nowadays are predominantly influenced by high competition in the banking sector, so banks are pressurised to make significant investments in assets, that add value to profitability of the bank, for example information technology. Investments such as in information technology can both inflate overhead costs and also negatively affect banks performance.
Under these economic constraints, banks depend on financial measures that can be used to assess banks efficiency. In that respect, the key objective of assessing and interpreting accurately financial measures is to ensure sustained profitability in that way a bank can maintain its capital resources. So bankers are keen on investigating into the cost of financial intermediation (COFI), which are measured by two dependent variables namely bank net interest margins and bank overhead expenditures (Demirg��-Kunt et al 2004,p.594).Bank managers always aim to maintain a strong and stable net interest margin as it is well known among banks that net interest margin indicate the earning performance namely the banks efficiency. Net interest can be expressed as interest income minus interest expense divided by interest-bearing assets while overhead costs as bank overhead costs by the total assets of the bank (Demirg��-Kunt et al 2004,p.595).In terms of overhead costs, bankers are mostly concerned about high overhead costs as they may indicate weak competition on the market, loan loss or even risks caused by political uncertainty. But there are significant factors that are positively and negatively associated with COFI,for example using data from banks covering 72 countries, a recent paper by Demirg��-Kunt, Luc Laeven, Ross Levine(2004) examine the impact of bank regulations, Market Structure, Institutions on COFI. The results in Demirg��-Kunt, Luc Laeven, Ross Levine(2004) indicate that restrictive banking regulations boost COFI and also in addition to bank-specific controls, property rights and regulatory restrictions become absolutely insignificant and do not provide any additional interpretations or explanatory reasons. The current credit crunch has also worsened banks performance as competition between banks is hampered as financial institutions do not have sufficient incentives to become more efficient.

Figure 1 shows the intermediation performance in transition economies in Europe. The net interest margin has shown steady decrease and fluctuations between 1995 and 2004 .Since 2004 banks are faced with significant deteriotion and analysts are urged in such situations to figure out whether the decrease in net interest margins are due to systematic reasons for example if the interest margins declined due to high competition on the market or of any cost related-influences. But in some cases, most banks, which are highly capitalized have higher margins and banks with high possession of liquid assets prefer to have lower net interest margins bank (Demirg��-Kunt et al 2004,p.607). One of the key purposes why banks intend to have high or low interest margins is obviously to avoid facing shortage of capital and standing to lose its business to its competitors, furthermore to provide stability and absorb losses, thereby protecting its depositors or credits incase of liquidation. The following sections cover the impacts of bank regulations, market structure, and institutions on COFI, because it is vitally important for bankers to pay a great deal of attention to factors that influence COFI, so that profits can be kept steady and also predictable as this attracts investors.

II. The impact of bank regulations on COFI

Studying whether bank regulations impact COFI is highly vital to examine whether banking regulations contribute to bank interest margins and overhead costs and its impact on COFI have positive or negative repercussions?.In the banking system, regulations and regulatory authorities always play a vital role, something that has always been thought to be done for the sake of the bank development and efficiency. Bank regulations,which "typically refer to the rules that govern the behaviour of banks" have been regarded as highly important since world-wide collapse of banks in the past (Barth et al., 2006, p.4). Banks have learned from the crisis that unregulated banking system can be too risky.

Regulatory Variables

Activity restrictions

Banking freedom

State ownership

KKZ Institution index

III. The impact of market structure on COFI

IV. The impact of institutions on COFI

V. Conclusion

Odean(1999) in his empirical study gives efforts to discover whether the trading profits of discount brokerage customers are enough to cover trading costs, but shockingly he finds that the securities investors buy did not perform well enough to cover the costs and also that these securities underperform those they sell. The study also leads to the conclusion that investors are engaged in excessive trading due to psychological factor, namely overconfidence.

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